1. Field of Invention
The present invention relates to an improved method of and system for mitigating payments risk, liquidity risk and systemic risk in the settlement of foreign exchange transactions and many other payments-based transactions.
2. Brief Description of Prior Art
Payments made through large value payment systems in all currencies globally total more than $4 trillion a day in average values. These payments are made up of individual payment transactions relating to specific underlying payment obligations incurred through trading in foreign exchange and financial markets, commercial lending operations, and trade in goods and services. Payments are all effected through the domestic payment systems operated within each currency area.
Participation in payment systems is generally limited to larger banks. Participant banks make payments to one another in these payment systems and other market participants, smaller banks and foreign banks will hold accounts with participant banks to effect payments on their behalf.
“Payment risk” arises in any case where one financial market participant makes payment(s) to another financial market participant in expectation of later receipt of other payment(s) in return, whether in connection with the same or different financial transactions. The expected receipt of payment may be in the same currency or in a different currency.
Failure to receive expected payments from a financial market counterparty or his intermediary—whether arising from operational causes such as computer failure, financial causes such as illiquidity, or legal causes such as bankruptcy—can cause substantial harm to financial market participants. They will suffer the effects of an unexpected shortfall equaling the amount of the failed payment. In the best case, this will imposes costs associated with borrowing or funding the amount of the shortfall, and in the worst case may cause contingent failures to pay their own obligations which were dependent on receipt of the expected funds. The ease with which illiquidity and loss of confidence can spread in financial markets itself creates the risk of system-wide disturbances from a single payments failure, known in the industry as “systemic risk”.
The single greatest component in payments traffic is settlement of payment obligations arising from foreign exchange trading. The foreign exchange (FX) markets in our world trade over $1 trillion worth of capital currencies daily. Economic order throughout the global banking system generally requires that parties engaging in such foreign exchange transactions make payments due thereunder in a timely manner to prevent default and the consequences associated therewith.
As shown in FIG. 1, the conventional method of making payments in connection with foreign exchange transactions, takes place over a standard 3 day cycle. On the Trade Date, various foreign exchange transactions are dealt either by telephone or electronic execution system between a User of the GPM system and a market counterparty. This is followed by the exchange of MT300 messages, in a prescribed industry data format, via a global bank communications network maintained by the Society for Worldwide Inter-bank Financial Transmissions (S.W.I.F.T). This global bank communications network, commonly referred to as the SWIFT network, is a proprietary value added network (VAN) which use electronic data interchange (EDI) message format standards. The International Standards Organization (ISO) recognizes S.W.I.F.T. as the organization responsible for the promulgation and maintenance of these message standards within the global banking industry.
Once the MT300 messages are matched in each party's back office, each party generates a payment instruction for the sold currency and a pre-advice for the bought currency to a bank's own branch, or a correspondent bank holding an account for the bank in a foreign currency. Where banks make payment using correspondent banks, they undertake payment for their own account, whether or not they are involved in an underlying transaction as principal or agent of a non-bank market participant. The message types most important to payments include the MT200 for own account payments, MT202 for general commercial payments, and MT210 Pre-advice of expected receipt of funds.
The correspondent bank uses the S.W.I.F.T. network to confirm transactions in an account back to the account holder. The most important messages for this purpose are the MT900 advice of debit to account, MT910 advice of credit to account, and MT950 statement of daily account activity. In short, correspondent banking is a mechanism used by banks to effect payments in currencies other than their own.
All payment message types reference the paying bank, the account holder (if any), the receiving bank, the counterparty account holder (if any), and the Transaction Reference Number, a unique number identifying the underlying transaction using the prescribed industry data format. Messages to correspondent banks are sent using the S.W.I.F.T. network. Messages in domestic payments systems are sent using the network facilities and formats prescribed by the individual domestic payment system.
Payments within domestic payment systems are currently managed by the construction of a queue of payments messages for a particular day within a bank directly linked to a domestic payment system. Liquidity management software is used to control the flow of payments messages from the queue into the domestic payment system for clearance, to monitor balances at the central bank, and to monitor payment conditions vis-a-vis other directly participating banks. The liquidity management software allows payments to proceed according to the priority of individual payment messages and the liquidity available in the system.
Settlement Date is normally two business days after Trade Date for spot transactions in foreign exchange, and can be much later for forward transactions. On the Settlement Date, each branch of a bank operating the link to the domestic payment system for a currency, or each correspondent bank acting as a nostro for other banks' payments in a currency, will construct a payments queue containing all the messages requiring payment on that date.
Where the payments are to be made via a real-time gross payment system or other system accommodating payment instructions on a real-time (as opposed to batch process) basis, the payments are released one by one as sufficient liquidity in the clearing account of the bank permits. Liquidity management software is used by banks connecting to these systems to keep track of the balance in the clearing account within the payments system and release payments as liquidity permits. Also, such software will generally ensure that sufficient balance or credit exists in the account of the account holder to cover the payment. Such software shall hereinafter be described as “liquidity/payments manager.” Payments made from the queue reduce the balance, while payments received from other banks in the system increase the balance. The process continues until all payments on the queue are sent.
Banks acknowledge payments and receipts to their correspondent banking account holders using the S.W.I.F.T. network, and to non-bank account holders using various methods. For correspondent banks, an MT900 is sent following debit of a payment from a client's account. An MT910 is sent following credit of a received payment to a client account. At the end of the day, an MT950 statement of account activity is sent to confirm every debit and credit through the account during the day, and the opening and closing balances, using an industry standard data format.
The Reconciliation Date is normally the day following the Payment Date. Institutions active in the foreign exchange markets typically take all the MT950 statements from all branches and correspondent banks acting on their behalf for settlement, and provide these statements as inputs to a batch process for reconciliation. This process determines whether for each payment made in respect of a trade, whether a counterpayment was duly received as expected. If payment has been made, but no counterpayment received, then the party is at risk for the gross amount of the payment as an unsecured creditor of the counterparty. An exceptions report is generated as a result of the reconciliation batch process, which is used for querying missed payments with counterparties, generally by telephone. Only after a query (often made difficult by geographical distance and time zone differences) can a decision be made about the credit-worthiness or potential default of a counterparty. As a result it can be two or three days following missed payments before a counterparty is declared in default and further payments are suspended. As a result of this process overall, the risk to a foreign exchange market participant, arising because payments are typically instructed on a transactional basis (as obligations are incurred) and are processed independent of other transactions which would result in expected receipts, may be as much as three days gross value of payments to a counterparty. This risk is known as “cross-border settlement risk” and is a variety of the broader category of “payment risk”.
Payments risk may well exceed the capital of a bank or other financial institution, raising a potential that a counterparty failure could cause their own insolvency, arising from the difficulty that financial institutions are likely to have raising funding rapidly to cover a shortfall should expected receipts fail to materialize on the payment date. This risk is known as “liquidity risk”.
Liquidity risk, in turn, may perpetuate a systemic impact throughout the chain of counterparties active in the financial markets, arising from payment failure due to liquidity problems, through a chain of co-dependent payments transactions. This risk is known as “systemic risk” and is a principal concern of central bankers and supervisors in overseeing the strength of capital markets. Payments risk, liquidity risk, and systemic risk associated with participation in payments systems are summarized in the table of FIG. 2.
Cross-border settlement risk in the foreign exchange markets has been exacerbated by recent trends in the markets. Many smaller participants now trade directly in the markets through electronic foreign exchange trading systems. The past five years have seen the market share of the top dealing banks fall from approximately 60 percent of the market to less than 40 percent of the market, demonstrating their displacement by more active smaller institutions. These smaller institutions tend to have lower credit ratings, and so present higher levels of payments risk to their counterparties. Additionally, there has been a shift toward increased trading volumes in the currencies of emerging economies. These currencies are generally less liquid and more volatile, particularly in conditions of general market uncertainty, and so present higher liquidity risk and systemic risk in the event of a financial failure.
In addition, there has been a movement toward more rapid settlement of transactions, with some transactions now settling on the same day as trading or the next day, as opposed to the customary two days following trade date. The shorter settlement times put pressure on banks involved in payments as they increase uncertainty as to liquidity, and are often inconsistent with existing systems for trade processing and reconciliation.
Hitherto, a number of prior art systems and methods have been proposed for mitigating or managing the various types of risk associated with making payments in connection with foreign exchange transactions in our global financial capital market system.
One proposed method of managing payment risk involves the “contractual netting” of payment flows, whereby parties agree to net all payment obligations for any given date and only effect net payments to one another.
Contractual netting requires that both parties sign an enforceable legal agreement to net their obligations, that the parties agree daily the specific amounts of the payment flows in settlement of transactions, and that the parties maintain systems for the reconciliation of payments against transactions to ensure that underlying transactions have been settled. Supervisors generally require independent legal opinions supporting netting enforceability before conferring any benefit of risk reduction for capital adequacy purposes. In consequence of its complexity and legal uncertainty in many countries, contractual payments netting embraces only one-quarter of transactions in foreign exchange markets.
In connection with the above method of risk management, a system referred to as FXNET exists for the calculation of bilateral netting exposures and net payment amounts in traded currencies for its participants. This system is designed to reduce the operational complexity of bilateral netting on a daily basis as between its users. It has less than 100 bank users.
In addition, two other systems have been proposed for providing multi-lateral netting, or clearing house, operations to the foreign exchange markets. The first system is the MultiNet system which never became operational, and was abandoned in late 1996. The second system is the Exchange Clearing House (ECHO) which was operational for several years, but operations were suspended in 1998 because they were deemed uneconomic.
CLS Bank has proposed an alternative method of managing risk in connection with foreign exchange transaction payment systems. This method involves developing a clearinghouse which seeks to provide a tiered system for clearing foreign exchange settlements, ending with value-for-value settlement of foreign exchange transactions through the agency of a special purpose bank with accounts at participating central banks. CLS Bank's clearinghouse is only effective for transactions wholly in the currencies admitted to the system (i.e. 7 currencies are proposed for initial operations), only market participants joining the CLS system or clearing through participants, and only for foreign exchange settlements. The CLS system requires substantial investment and changes to existing systems for reporting and matching of transactions, and for payment and liquidity management among participants. Even if CLS Bank were to settle all eligible foreign exchange trades for all its 60 shareholder banks, this would only address the risk on 27 percent of foreign exchange market transactions.
Although the foreign exchange markets account for the single greatest proportion of payments, they represent only about half of all payments by value. Banks assume risk on one another in domestic payments systems for all their payment transactions with one another. The risk arises because payments are generally made and received through domestic payments systems without regard to the payment imbalances which may accrue between any two payment intermediaries or account holders.
Hitherto, a number of prior art systems and methods have been proposed for mitigating or managing domestic payment risk associated with making payments in domestic payment systems.
One proposed method of managing payment risk involves the netting of payment flows throughout the operating hours of a payment clearing house, with settlement of the net balance by transfer of funds periodically during the day or at the end of the day. Participating banks agree with one another contractually to net all payment obligations for any given date as payments are processed by the clearing house. This method requires both banks involved in a payment to be participants of the clearing house and to route payments through the clearing house.
A bank participating in a net clearing house for payments processing will incur a payment risk exposure on any other bank participant for the net imbalance of payments in its favor pending actual transfer of the funds in settlement of the net payment obligation. Some clearing houses impose bilateral net debit caps on their bank participants to limit the amount of exposure thus assumed during the day. Others additionally provide collateralisation, guarantee or loss-sharing schemes which contractually allocate the losses which may arise in the event that a participant's default on its net payment obligations.
Real-time gross payment systems provide for the real-time transfer of cash balances on the books of a central bank, providing instant finality of payment in cleared funds. Banks participating in these systems must have cash balances available with the central bank to cover payment instructions, or have secured overdraft or collateralised lending facilities to cover any shortfall. Real-time gross payment systems therefore create greater pressures on liquidity during the business day, as payments may be blocked from timely processing due to inadequate liquidity. Each bank will be dependent on the payment performance of other banks for the liquidity required to enable release of payments, with disruption transmitted very rapidly throughout the system in the event of a persistent payment failure by any one participant, whether due to operational or credit conditions.
Overdraft and collateralised lending facilities are the principal methods for managing intraday liquidity demand in real-time gross payment systems. Overdraft facilities expose a central bank to the risk of loss in the event of a payment failure, so are generally limited in amount and only available in some few currencies. Collateralised lending facilities require the posting of securities, typically government bonds, as collateral for overdraft facilities in the payment system. Collateralisation creates an added expense for bank payment processing and a drain on the liquid securities available to the participating bank to pursue other business.
A further variation of domestic payment systems arises in some systems where individual banks are very dominant. These banks may hold accounts for a substantial portion of commercial and financial entities making payments in the currency, and may therefore be in a position to accomplish payments on behalf of account holders by transferring balances between accounts on their own books without recourse to domestic payment channels. These so-called “book transfers” should be considered a further payment channel, but are governed by the rules created by the bank itself.
Whatever the nature of a payment, in the case that a financial market participant is not itself a direct participant in a payment system, it will rely on a bank as intermediary to effect the payment on its behalf through an account with the bank. In such cases, the account holder has very limited control on the timing of the payment and the risk it may incur on other payment counterparties or intermediaries in the currency.
The only method currently available to account holders for control of payment risk today is the withholding of payment instructions until confirmed receipt of expected payments is recorded. This process, used by only a handful of market counterparties in a handful of currencies, creates a systemic illiquidity problem. The withholding of payments by these few indirect participants impairs the liquidity available to their payment counterparties, and by extension the payment system as a whole.
All payments transactions to financial market participants who are not direct participants in a domestic payment system will involve one or more intermediary banks in the chain of accounts to the ultimate payment beneficiary. Payment risk will arise on these intermediary banks as payment to the ultimate beneficiary is dependent on their performance. For this reason it is important to be able to separately identify and control risk on financial institutions as payment intermediaries.
In summary, prior art methods of and systems for managing risk in connection with FX and other payments transactions throughout the world suffer from the following shortcomings and drawbacks: they require agreement of the transaction counterparty; they do not extend to non-bank counterparties; they are complex and difficult to implement; and they do not adequately enable a typical foreign exchange or other market participant to control the risk arising in respect of the plurality of its counterparties, currencies and payment types.
Consequently, there is a great need in the art to provide an improved method of and system for mitigating risk associated with participation in payments systems involved in settling foreign exchange and other financial transactions.